When should I form my LLC?

The Short Answer:

Its a common misconception that the first step when you have a business idea is to form a LLC. LLCs are fairly simple to create but can get expensive with annual fees in some states and they are a nightmare to dissolve if you end up shuddering the operations.

You should operate as a sole proprietor until you start taking on more risk from a liability standpoint than you are willing to absorb personally or when you want to bring on a co founder or partner and formalize an operating agreement.

In some cases I recommend keeping a personal LLC active with a general name that is not limited to just one of your business ideas. This can act as the home of all of the new businesses (as long as there are not partners involved) and can limit liability along the way.

Expanded Answer:

The sole proprietorship is great and can be utilized by some entrepreneurs for the lifetime of a business.

You can operate as a sole proprietor quickly without a lot of paperwork, fees, or reporting. Simply file your doing business as (DBA) name with your state agency and you can open a bank account and get insurance policies. Sole proprietorships can even obtain an EIN fairly simply and start hiring employees and running payroll.

Advantages of the Sole Proprietorship:

Less reporting. When you file an LLC you are often required to report new hires, report sales tax, report payroll, pay an annual fee and more. Dissolving an LLC if you decide to shutter your business is also a big process and there are several forms to submit and agencies to notify.

Staying organized with finances is something I preach but is often overlooked and a sole proprietorship is much easier to keep track of.

If you operate in a space with low risk of personal injury (like graphic design, accounting, photography, web design) and you do not plan to bring on partners you can operate as a sole proprietorship for a very long time without issues. Make sure to file for an EIN when you decide to hire employees and get your workers compensation insurance, etc.

Advantages of the LLC:

Limited Liability. Risk. You have a safety net between your personal assets in the event that you or your employee injures someone while on the job. If you are out driving large vehicles and operating equipment that is dangerous (even a lawn mower) an LLC provides much more protection. If you have a lot to lose in the form of personal wealth, a home, etc you should form your LLC earlier if you are offering a service with some risk involved.

Risk is the reason that Delaware is so popular for LLC registration. It has laws that protect the owners of companies much better in the event of creditors or personal injury attorneys chasing you down. Note: there are no tax advantages of an LLC in the early stages. You are still taxed in the municipality where you operate and do business. Make sure to register to do business in your state if you do form a Delaware LLC.

Every LLC has an operating agreement and this makes it the necessary route if you have partners or co founders involved. I like to make sure my OAs have a buy sell agreement included. This states what happens if one person leaves, gets divorced, passes away or is otherwise forced to leave the company. I like to put valuation methods inside my buy sell so there isn’t a bunch of time and money wasted arguing over how much the company is worth. 3x before tax income (after compensation to owners) is the formula I like for service businesses. I also like to include payment terms in the buy sell so it does not cripple the business with a large expense that isn’t manageable for the other owners.

With an LLC you have the ability to elect a few different tax treatments. This is fairly complicated and I’m not going to get too far into it here. Generally most LLCs elect to be taxed like an S corp and the income passes through directly to the owners in the form of income tax. Another option is to request C corp tax treatment where you are taxed like a corporation. There are advantages to this because some income can be taxed at the capital gains rate of 15%. But if you pull that money out later in the form of an owner's draw it gets taxed again on the personal level. You must be careful to avoid double taxation here. If you are interested in this dive into this book!

The Personal LLC

Entrepreneurship is a process and you often start and move on from several businesses before you find one that sticks.

Many people, and I’m a proponent of this, create an LLC as a personal entity to limit the liability on all of the startups or small businesses they might pursue. I’m talking about small concept generation and exploring ideas without much revenue.

They run all the finances for all the startups through this one entity and file a tax return for it each year. They create DBA (doing business as) names for each company as they go along and remove them as they shutter businesses. When they start a company that sticks they then change the name and focus that LLC on that business.

I hope this helps and reach out if you have any questions!

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